The consequences of these ultra-low and negative yields will be felt across both households and institutions. Savers of both the household and institutional variety will have to think about other sources of yield.
How are investors likely to react?
For many, the first port of call will be UK Gilts and US Treasuries. It is simple to hedge the currencies and arguably have better credit quality. These bonds, with respective yields of 1.65% and 1.98%, offer similar income levels to, for example, Italian government bonds, but with significantly better credit risk.
Then we believe the reach for yield will spread into emerging market debt. Hard currency bonds will no doubt be preferred, but we expect local bonds will eventually be bought as well.
Property, particularly in “core Europe”, is also likely to benefit. Why lend to the government for a near-zero return when you can buy an appreciating asset in, say, German property? German real estate remains fairly inexpensive on an international basis and comes with good yield levels. German property should benefit from the near-zero interest rates on offer in Europe; a one-size-fits-all interest rate policy is likely to be too tight for the periphery and too loose for Germany, creating some asset price inflation. Core European real estate is one of the natural places for investors to turn to in today’s environment.
Finally, the same negative interest rates will ultimately drive investors into equities, specifically for income. The EURO STOXX 50 index, with a dividend yield of 3.47%, is providing better income-level returns than the bond market. Particular beneficiaries of this trend are likely to be the stocks paying out healthy, regular dividends.
European equities don’t require a booming economy to do well
The economic picture in Europe is far from clear, and we have seen both positive and negative signs emerging. On the plus side, core Europe, particularly Germany, continues to do well, and some parts of the periphery have started to recover decently, such as Ireland and Spain, although the latter is in the earlier stages. Credit appears to be easing across the region, and the ECB’s actions in starting quantitative easing will likely help this trend. However, some economies, in particular Italy, are facing an extremely lacklustre year, which will make it much more difficult to implement structural economic reforms which are necessary to tackle their debt.
On balance, we expect modest levels of economic growth to contribute to a modest recovery in Europe. The ongoing recovery in the US will no doubt aid growth in Europe.
For stocks, this uninspiring outlook isn’t entirely bad. The single currency’s weakness should help earnings. Many listed European companies export outside the Eurozone and benefit from the cheaper euro, which has weakened by around 11% over the last year on a trade-weighted basis. On its own we expect this to lead to 5% to 6% earnings growth in Europe in 2015.
‘Kicking the can down the road’ might just be a good thing (so long as you are not a German taxpayer)
The ECB has come under a lot of criticism for ‘kicking the can down the road’ by delaying the day of reckoning for peripheral European countries and their mountains of debt. Quantitative easing, some argue, just delays the inevitable.
This criticism misses the point. At a regional level the Eurozone does not have an excessive debt problem. It has a political problem: how to pass the debt burden from the periphery to the core without too many voters noticing. The ECB may well be kicking the can down the road, but if along that road the principle of debt mutualisation – risk-sharing across European nations – becomes slowly established and accepted, then the problem will be solved.
In my view, it is inevitable that debt mutualisation will quietly and stealthily come about. It just needs time.
For example, there is likely to be another restructuring of Greek government debt. This is explicit debt mutualisation. Northern European savers facing zero interest rates for many years to come are another form of cross-subsidy. On top of structural payments from the European Union budget, other subsidies such as communal infrastructure spending are both implicitly and explicitly designed to share the burden of debt. Ten years from now, debt mutualisation will have occurred – though it will not be signposted as such.
Impact on our portfolios
In 2014 the preference of the Baring Global Multi Asset Group was for Japanese and US equities. In 2015 we retain our positive stance on Japan, but in place of the US we have shifted towards European equities and core European real estate investment trusts. Various aspects support our position: a high dividend yield, negative interest rates on many bonds, and earnings improvement from the cheap euro. The facts have changed, and we are shifting to capture the opportunity that exists in Europe today.
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